Austerity Measures, Do They Work, with Examples

Austerity measures are reductions in government spending, increases in tax revenues, or both. These harsh steps are taken to lower budget deficits and avoid a debt crisis.

Governments are unlikely to use austerity measures unless forced to do so by the bondholders or other lenders. These measures act like contractionary fiscal policy. They slow economic growth. That makes it even more difficult to raise the revenue needed to pay off sovereign debt.

Austerity measures require changes in government programs. For example, they:

• Limit the terms of unemployment benefits.
• Extend the eligibility age for retirement and health care benefits.
• Reduce government employees' wages, benefits, and hours.
• Cut programs for the poor.

Austerity measures also include tax reforms. For example, they:

• Raise income taxes, especially on the wealthy.
• Target tax fraud and tax evasion.
• Privatize government-owned businesses. These are industries considered vital to the state's interest. They include utilities, transportation, and telecommunications. Selling them will raise revenue to pay off debt.
• Increase value-added taxes.

Other austerity measures reduce regulations to lower business costs. They require governments to:

• Remove some of the protections against wrongful terminations.
• Lower or eliminate the minimum wage.
• Increase workers' hours.

Austerity measures may not include all of these changes. It depends on the country's situation.

Why Countries Agree to Austerity Measures

Countries use austerity measures to avoid a sovereign debt crisis. That's when creditors become concerned that the country will default on its debt. It occurs when the debt-to-gross domestic product ratio is greater than 77%. That's the tipping point, according to a study by the World Bank. It found that if the debt-to-GDP ratio exceeds 77% for an extended period of time, it slows economic growth. Every percentage point of debt above this level costs the country 1.7% in economic growth.

The tipping point for emerging market countries is 64%. If the debt-to-GDP ratio is higher, it will slow growth by 2% each year. Creditors then start demanding higher interest rates to compensate them for the higher risk.

Higher interest rates mean it costs the country more to refinance its debt. At some point, it realizes it can't afford to keep rolling over debt. It then turns to other countries or the International Monetary Fund for new loans. In return for bailouts, these new lenders require austerity measures. They just don't want to bankroll continued spending and unsustainable debt. 

Austerity measures restore confidence in the borrowing country's budget management. The proposed reforms create more efficiency and support a stronger private sector. For example, targeting tax evaders brings in more revenue while supporting those who do pay their taxes. Privatizing state-owned industries brings in foreign expertise. It also encourages risk-taking and expands the industry itself. Instituting a VAT or value-added tax reduces exports by making them more expensive. This protects local industries, allowing them to grow and contribute to the economy.

Examples 

Greece - In 2014, the European Union imposed austerity measures during the Greek debt crisis. Greece's austerity measures targeted tax reform. Lenders required Greece to reorganize its revenue collection agency to crack down on evaders. The agency targeted 1,700 high-wealth and self-employed individuals for audits. It also reduced the number of offices and set performance targets for managers.

Other specific measures required Greece to:

• Reduce overall government employment by 150,000.
• Lower public employees' wages by 17%.
• Reduce pension benefits above 1,200 euros a month by 20%-40%.
• Raise property taxes by 3-16 euros per square meter.
• Eliminate the heating fuel subsidy.

The Greek government agreed to privatize 35 billion euros in state-owned assets by 2014. It also promised to sell an additional 50 billion euros in assets by 2015. The IMF Memorandum provides more details on this.

Layoffs, tax hikes, and reduced benefits curbed economic growth. By 2012, Greece's debt-to-GDP ratio was 175%, one of the highest in the world. Greece's recession included a 25% unemployment rate, political chaos, and a weak banking system.

European Union - The Greek debt crisis led to a crisis in the eurozone. Many European banks had invested in Greek businesses and sovereign debt. Other countries, like Ireland, Portugal, and Italy, had also overspent. They took advantage of low-interest rates as eurozone members. The 2008 financial crisis hit these countries hard. As a result, they needed bailouts to keep from defaulting on their sovereign debt.

Italy - In 2011, Prime Minister Silvio Berlusconi increased health care fees. He also cut subsidies to regional governments, family tax benefits, and the pensions for the wealthy. They voted him out of office. His replacement, Mario Monti, raised taxes on the wealthy, raised eligibility ages for pensions, and went after tax evaders.

Ireland - In 2011, the government cut its employees' pay by 5%. It reduced welfare and child benefits and closed police stations.

Portugal - The government cut wages by 5% for top government workers. It raised VAT by 1% and increased taxes on the wealthy. It cut military and infrastructure spending. It increased privatization.

Spain - Spain raised taxes on the wealthy. It also increased tobacco taxes by 28%.

United Kingdom - The U.K. eliminated 490,000 government jobs, cut budgets by 19%, and increased the retirement age from 65 to 66 by 2020. It cut the income tax allowance for pensioners and reduced child benefits.

France - The government closed tax loopholes. It withdrew economic stimulus measures. It increased taxes on corporations and the wealthy.

Germany - The German government cut subsidies to parents. It eliminated 10,000 government jobs and raised taxes on nuclear power.

United States - Although it was never called by the name "austerity measures," proposals to reduce the U.S. national debt took center stage in 2011. A stalemate over these austerity measures led to the U.S. debt crisis. Spending cuts and tax increases became an issue. Congress refused to approve the Fiscal Year 2011 budget in April 2011, almost shutting down the government. It averted disaster by agreeing on mild spending cuts.

In July, Congress threatened to default on the U.S. debt by not raising the debt ceiling. It again averted disaster when the two parties agreed to a bipartisan commission to study the matter. Congress also imposed a budget sequestration if nothing was resolved. This mandatory 10% budget cut would occur, along with tax hikes, in a situation known as the fiscal cliff. Congress resolved it with a last-minute agreement. It delayed sequestration, raised taxes on the wealthy, and allowed a 2% payroll tax credit to expire.

Why Austerity Measures Rarely Work

Despite their intentions, austerity measures worsen debt and slow economic growth. In 2012, the IMF released a report that stated the eurozone's austerity measures may have slowed economic growth and worsened the debt crisis. But the EU defended the measures.  It said they restored confidence in how countries were managed. For example, Italy's budget-cutting calmed worried investors, who then accepted a lower return for their risk. Italy's bond yields dropped. The country found it easier to roll over short-term debt.

The timing of austerity measures is everything. It’s not a good time when a country is struggling to get out of recession. Lowering government spending and laying off workers will reduce economic growth and increase unemployment. The government itself is an important component of GDP. Likewise, raising corporate taxes when businesses are struggling will only cause more layoffs. Raising income taxes will take money out of consumers' pockets, giving them less to spend.

The best time for austerity measures is when the economy is in the expansion phase of the business cycle. The spending cuts will slow growth down to a healthy 2%-3% rate and avoid a bubble. At the same time, it will reassure investors in public debt that the government is fiscally responsible.